The reasons behind the market's turbulent start to 2022 and why the bears are not yet in control

Published Sat, Jan 15 20229:25 AM EST

Whenever the Federal Reserve prepares to tighten, Wall Street tenses up. As economic and earnings growth downshifts, the market's gears tend to grind or slip. When leadership is being handed from one style of stocks to another, the baton is sometimes fumbled. This is the story of 2022 so far: A market rushing to reprice for an inflation-hunting Fed testing investors with tough talk. The aggressive valuation premium granted to dominant mega-cap growth stocks since 2019 being drained and the flow of capital redirected toward financial and oil stocks riding the economy's top line growth. Investors squinting hard to look through the Omicron soft patch in travel and consumer spending as Treasury yields lift and pandemic-beneficiary stocks struggle. It's made for an unsteady, discomfiting tape even without the broad S & P 500 backsliding much or slipping from its months-long uptrend. The Nasdaq Composite somehow outperformed the other major indexes last week with a quarter-percent dip sandwiched around a 2.5% drop Wednesday. The S & P is off a mere 3.2% from its record intraday high yet nearly half the stocks that make it up are down at least 10% from their peak. The high-torque rotation into financials and energy in particular appears popular, intuitive – somehow even virtuous to professional investors who often have a hard time buying, say, a full 6.8% portfolio allocation of Apple to match the S & P 500 weighting and ride the mega-cap momentum. Yet even here, the migration is starting to appear a bit fevered in the short term, the S & P 500 energy group up 16% this month and the value-over-growth surge flashing some extreme overbought readings. Big bank stocks mostly sank on respectable profit reports Friday, in part reflecting that their valuations (on earnings and book value) are near the high end of their dozen-year range. To a significant degree, all this was predictable, and indeed predicted. The typical call entering 2022 was indeed for a choppier, less generous market, with valuations working lower, as the economy moves through the mid- or late-cycle phases and as the past three years' 100% ramp is digested. Tony Dwyer, strategist at Canaccord Genuity, noted at the end of 2021 that following years when the S & P gained at least 25% (it was up 27% last year) there has been a median drop of 5% in the early part of the following year. He's advising that investors buy such a break, though Friday he suggested the tactical setup didn't show enough of a flush to get aggressive in doing so yet. Goldman Sachs strategists mapped out S & P 500 performance along a grid plotting Treasury yields and GDP growth. Since 1975, the weakest returns outside of contractionary, bear-market periods matched current dynamics with yields rising and GDP growth positive but decelerating. Average annual gains were 8%. Market around Fed hikes The market is also roughly conforming to the observed patterns ahead of a first rate hike in a cycle, which tends not to end a bull market but can feature scares along the way. The S & P 500, on average, is up in the six and twelve months before the start of a tightening cycle. If, as the market is now almost fully expecting, the first quarter-point hike from the Fed comes March 16, six months before that would be Sept. 16, when the S & P 500 closed at 4473, 4% below Friday's close. The Nasdaq 100 and Russell 3000 also happen to be a 4% drop from visiting their 200-day averages, which makes that degree of further downside a decent mental marker of what would separate normal turbulence from a possible consequential trend change. Another level to bear in mind is about 4500 for the S & P 500, the early December low. An old Wall Street maxim says if the market breaks below its December low early in a new year, it can mean a more bearish weather system arriving. Ned Davis Research plots the market's performance around an initial rate hike here by distinguishing between fast and slow tightening cycles. Fast is something close to a hike at every Fed meeting. (A non-cycle is one where no recession occurred between easing and tightening, does not apply now.) The market has had to hustle to price in several bumps in short-term rates in response to pointed Fed messaging, though it's not yet clear if a fast hiking path is truly ahead. Bespoke Investment Group notes the bond market since Sept. 21 has gone from anticipating 15 basis points of tightening in 2022 to more than 82. The chance of that March Fed hike is now viewed as a layup. And investors have effectively tightened up liquidity by smothering the valuations of first the riskiest, most expensive growth stocks and now compressing the premiums in the highest-quality Nasdaq giants such as Microsoft, Nvidia and Salesforce.com. A tamer Nasdaq bust? How much more of this might we see? Impossible to say, but for context the Nasdaq 100 ran from around 22-times forward 12-month earnings forecasts before the pandemic to a peak of 30-times as of two months ago. The multiple is now at 27.5. Must this work its way back toward 22 through some combination of further share declines, higher profit forecasts and time? There's a nagging thought shared by those who were around for the late-'90s tech boom and bust that a somewhat tamer version has been underway, the New Era bullish arguments and the rampant IPO speculation and software and Internet stocks valued on vaporous hopes for corralling a huge digital market. The bust back then ravaged the marginal, newly public stocks, then eventually reached the undisputed winners of the Nasdaq. Those companies (Microsoft, Intel, Cisco) kept growing nicely but once momentum broke and money was rationed with an eye toward valuation, the stocks went down relentlessly over more than two years. This meltdown in growth stocks was mostly responsible for the great relative renaissance of value investing in the early 2000s – it was not about great absolute gains in value stocks. This is not a prediction; even at the recent peak the valuation excesses paled relative to those from 2000. But, again, the thought nags. A plausible reason why the market as a whole has absorbed the quickly shifting monetary-policy outlook is the starting point at the loosest-ever financial conditions, based on central-bank policy, credit spreads and the like. (Lower is looser on this chart.) So far, corporate credit markets have remained steady against the choppy equity tape. Deutsche Bank notes that the S & P 500 gains ground during earnings-report season in recent years 80% of the time, for what that's worth. And next week brings both a heavier run of profit reports and a pre-meeting blackout on public remarks by Fed officials. These, at least, are reasons for investors not to presume the bears are now in control, in an admittedly irresolute market that is undergoing more a fitful transition than urgent retreat.

U.S. Federal Reserve Board Chairman Jerome Powell speaks during his re-nominations hearing of the Senate Banking, Housing and Urban Affairs Committee on Capitol Hill, in Washington, U.S., January 11, 2022.

Graeme Jennings | Reuters

Whenever the Federal Reserve prepares to tighten, Wall Street tenses up.